It is hard to believe that it is the end of the year already! As I write this article in early November, some of my neighbors already have their Christmas lights up. One year-end project at our offices is a client who had a large and valuable piece of property taken from him by a city through eminent domain – a case that inspired this month’s article. When a property is taken by eminent domain, tax deferral options are different than with a standard property sale. These differences could be very beneficial to you financially.

What is an Eminent Domain “Taking?”

Here in the United States, the government (Federal, State and local), has the power to take land from a legal landowner “for public use.” The law prescribes that “just compensation” be paid to a landowner in such a situation. This just compensation should be the market value of the property. If you are contacted by a government agency regarding eminent domain proceedings on a property that you own, it is important that you retain an attorney experienced in such matters to represent your interests.

A sale of a property by eminent domain is taxed the same way as any other property sale – the Federal government, State government, and Obamacare will all want to tax your proceeds. In a “regular” sale of investment property, we have the 1031 Exchange available to defer these taxes (potentially forever) with the purchase of a replacement property. For eminent domain sellers, the opportunity to defer these taxes (potentially forever) exists as well – but with what is called a 1033 Exchange.

Defer Taxes Like a 1031 Exchange

A 1033 Exchange is very similar to the 1031 Exchange you may be more familiar with – but with a few large differences. With your sales proceeds, you’ll buy a replacement property (or properties) and completely defer your taxes. The differences are:

A Longer Time Period to Buy Your Replacement Property (or Properties)

With the 1031 Exchange, you have 45 days to identify something you might buy and 180 days to close on a purchase. 1033 Exchange investors can take up to 2 years from the sale to close on their replacement property purchase(s).

No Accomodator Necessary

A 1031 Exchange requires an Exchange Intermediary or Accomodator to hold your sales proceeds and then send your funds directly to the seller to fund your replacement purchase. With a 1033 Exchange, you can receive the funds directly and place them in your bank or brokerage account. If you would like to hold the funds in a money market account or buy bonds, stocks, or even fix and flip a house in that 2 year window – you are free to do so.

Be careful that you don’t get too comfortable with the idea that 2 years is “plenty of time.” I have seen a lot of investors wait too long and find themselves unable to find what they want or make alternate decisions as their 2 year deadline approached.

Just Replace the Value

As an investor, my favorite difference is that 1033 investors just need to replace the value of the property they sold.

A completely tax deferred 1031 Exchange will require reinvesting all your equity and replacing all your debt. My investors know that a landlord who sells a property for $5 million, pays off a $2 million loan and has $3 million of equity at his accommodator will need to spend all of his $3 million of equity and assume a loan of at least $2 million if he wants a completely tax deferred exchange. If he would like to take $1 million of his equity to buy a boat, and exchange the rest of his proceeds, he is free to do that, but he’ll need to pay taxes on the $1 million of “cash boot” he received.

If the investor above was doing a 1033 exchange, however, he would only need to replace the $5 million sales price. He could invest just $750,000 of cash proceeds in a property that is leveraged at 85% and assume $4,250,000 of debt to buy that $5 million replacement property. The IRS would consider this transaction “fully tax deferred” and our investor would still have $2,250,000 of tax-free cash in his account. Now you see why this is my favorite difference!

Benefit Of That Tax-Free Cash – Even If You Want to Invest Back in Real Estate

If our investor wants to put that $2 ¼ million back into the real estate market, he can benefit greatly from this 1033 exchange through resetting his depreciable basis. Properties that have been held for decades often yield low or no depreciation. If he purchased a 50% leveraged property with that equity for $4,500,000, ($2,250,000 equity and a $2,250,000 loan), his annual depreciation deduction would be $130,900 if he used an 80% improvement value and bought a residential property. (Depreciated over 27.5 years.) At almost 6% of his invested equity – received annually – that amount can defer taxes (again – perhaps forever) on a lot of income.

“Losing” a property to eminent domain may sound like a bad thing, but the process could unlock a lot of valuable tax benefits for you. If you have any questions, please call my office toll-free at (877) 313-1868.

Christopher Miller is a Managing Director with Specialized Wealth Management and specializes in tax-advantaged investments including 1031 replacement properties. Chris’ real estate experience includes work in commercial appraisal, in institutional acquisitions for a national real estate syndicator and as an advisor helping clients through over five hundred and fifty 1031 Exchanges. Chris has been featured as an expert in several industry publications and on television and earned an undergraduate business degree and an MBA emphasizing Real Estate Finance from the University of Southern California. Chris began his real estate career in 1998. Call him toll-free at (877) 313 – 1868.

Securities offered through Emerson Equity LLC, member FINRA/SIPC. Emerson Equity LLC and Specialized Wealth Management are not affiliated. All investing involves risk. Always discuss potential investments with your tax and/or investment professional prior to investing.